Private Equity Industry 2009

Thoughts on 2009′s “New Normal” in Private Equity

It seems everyone is trying to anticipate changes to the private equity industry and how it will effect individual firms and investors. Whether it is the FDIC allowing private equity firms to invest in banks, states outlawing the use of placement agents, a boost in the IPO market or a recovering public market; there are major changes taking place following the major financial crisis. Some of these changes may be permanent while others will likely be temporary and adapt as the economy recovers.

Australian private equity blog Carried Interest recently looked at what the long-lasting fundamental shifts will be, those that last at least 3-5 years. I was writing a comment on his predictions but it evolved into a small essay so I’ve included it here. He believes that the “New Private Equity Normal” will include the following factors–to which I added my two cents:

Fewer firms: Carried Interest estimates a 30-50% reduction in the number of private equity firms in the next few years. I find this a bit high, if nothing else simply based on the volume of e-mails I receive from individuals and firms looking to open a private equity firm. Whenever a financial industry has a tough year observers speculate that a huge portion of the industry will dissolve. For example many observers were writing the epitaph for the hedge fund industry at the end of last year but August marked the sixth straight month of positive returns and hedge funds are posed to have the best year in a decade. I hesitate to suggest that private equity is about to have such a massive and rapid recovery.

But there is enough monetary incentive remaining as the 2/20 model has not been drastically reduced and investors are returning slowly. In 2009 fundraising was off to a dismal start in Q1 but increased 28% in Q2. It’s to be expected that fundraising would be incredibly tough but as confidence returns to the market I don’t see much warranting a cut in the industry by half.

As for existing portfolio companies, these firms should do better as the economy recovers and consumption increases (unless it’s a double-dip recession as Nouriel Roubini suggests). If the capital many private equity firms have had to inject does not overburden them with debt and if portfolio companies are able to generate profits again, then most firms may be able to escape bankruptcy. Of course, it’s tough to estimate anything in this economy but most economists have agreed that the worst is behind us in the financial markets at least. A recovery in the IPO market also suggests that private equity activity will recover in the next year as more buyouts take their companies public and find new investments. I think it might be healthy for the industry if it consolidates a bit but a reduction by 30-50% is quite severe and, I think, unlikely.

Much less debt: I do agree with Carried Interest on the reduction of debt, but maybe not to the 50/50 debt to equity ratio as a standard. It’s hard to imagine that big buyout firms will limit their debt use without a strong push from investors but maybe they are realizing that the potential risk and the concern to investors warrants a shift.

Tougher fund terms: This is an almost certain reality and I believe the terms that limited partners are able to push through will remain the standard unless private equity firms are able to have an amazing year that demands reevaluating their agreements. Again the 2/20 model will largely stay intact it seems although some firms have reduced their fees to entice wary investors especially at new private equity firms. However limited partners are gaining ground in other areas such as distribution waterfall, greater influence on the investments through advisory boards, and other aspects of the LPA. I tend to see term agreements as a tug of war and as institutional investors succeeded in gaining ground it takes twice the effort for private equity firms to recover that loss especially without a really great year.

Longer hold periods: Considering the losses that private equity firm’s portfolio companies racked up in the recession, it’s reasonable that PE backers will want to hold onto these investments longer in order to realize their full value. There was a time this decade where buyouts departed from investing long-term, but that may be over.

Continued development of GP operating skills: Private equity has been evolving its methods and strategies consistently over the last two decades and the pressure to keep increasing returns will ensure that General Partners continue to develop and implement new techniques and ways to increase profits. As Carried Interest writes, “Leverage and multiple expansion are no longer available to drive easy returns. GPs are going to have to build value through earnings growth . . . and that means (really) helping improve portfolio company performance. McKinsey predicted this trend years ago, but the credit boom and strong equity markets allowed many PE managers to cheat, to rely purely on financial engineering. The future? Look at firms like KKR. They have a team of 40 consultants called Capstone whose sole focus is on building value within the KKR portfolio.“

As always, this is not financial advice nor is it a guaranteed prediction of the private equity industry. Please see a qualified legal or financial consultant before following any prescriptions in this website.

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